The
Website
The Investment Science website at www.investmentscience.com has been recently
revised. You will find copies of past issues of this
Newsletter at the site, as well as additional information about
investment science projects and software tools. Your comments
on the site are welcome.
Stanford
Projects Course
As part of the Stanford academic program
in Investment Science, Robert Luenberger teaches a course for
graduate students titled "Investment Practice". In this
course, students who have studied the theory of investment science
work on real projects for real companies. In some cases these
projects have been originated by past participants of the
Investment Science for Industry course (that is, from people like
you). There is no cost to the sponsoring company for
such a project, but the project must fit into a one-quarter time
frame. This year the course begins at the end of March.
If you have a potential project, contact Rob at Onward, Inc. 650-943-1703 or
rob@onwardinc.com.
Short Course
News
Investment Science for Industry was given at
Stanford last September. Our example projects are expanding
and we have a new overview of the role of options in project
design. The course continues to provide us with inspiration
in our research and graduate teaching.
The course will next be given this April
26-27. Past participants have referred colleagues to the
course, and this is very much appreciated. I hope you will
consider presenting the idea of the course to your
colleagues. You may refer them to the course through the web
site http://www.stanford.edu/~luen/investment
or to the www.investmentscience.com website
mentioned above.
Options
Directions
Options theory as applied to business problems has evolved
substantially in the past few years. Many more people are
aware that there is something powerful embodied in the real options
approach and that it has great benefits compared to simple
discounted cash flow analysis. However, we have always
emphasized that the underlying concepts are more general than their
use in real options, and we have used the term Investment Science
as a term that encompasses all of modern finance, without the
limitations of real options.
In this short discussion, we will sketch a few layers of options
theory, with emphasis on how the theory relates to business issues
and how it is becoming more general.
1. Stock Options. The Black and Scholes analysis of stock
options in 1972 was a breakthrough in modern finance. The
approach was truly revolutionary, for it showed how the value of an
option on a stock could be related to the value of the stock
itself. Basically, the theory related the dynamic behavior of
the option to the dynamic behavior of the stock. A shorthand
way to explain the theory is that since the option value in the
future will depend, day by day, on the stock value, it must be
possible to trace the relation backward in time to find the current
option value. The stock is an underlying security, and its behavior
contains all the uncertainty about the option.
2. Real Options. A few years after the introduction of
the Black-Scholes theory, researchers began to apply options theory
to options on physical items, such as gold mines, oil fields, and
so forth. These were termed real options. The
associated traded commodity (e.g. gold or oil) served as the
underlying security. This approach was quite successful,
except that the number of problems that fall into this category is
limited.
3. Project Options. Next, the theory was applied to
general business projects, such as new-product development,
marketing campaigns, supply chain operations, and so forth.
Many people did (and still do) attempt to apply the Black-Scholes
theory directly to these situations. However, this is
incorrect. Unlike stock options or even real options on
physical commodities, there may be no pure underlying security
associated with a project option, and hence the basic assumptions
of the Black-Scholes method do not hold. For example, some
practitioners (mis)applied the Black-Scholes method to electricity
pricing with disastrous results, since electricity is not
storable. At Stanford we have worked on project options for
several years, and have developed the appropriate modification of
the Black-Scholes approach, which recognizes that there is, at
best, only partially related underlying securities associated with
business projects. We now have a methodology that is
both rigorous and well suited to application, and we have worked
with several companies on specific projects. In the two-day
course, we include examples for which there is not a strict
underlying security.
4. Interactive Business Model Options. The next level
deals with issues associated with business model
alternatives. Although some business model decisions can be
regarded as project options, many such decisions involve relations
with other companies or depend on what other companies do.
For example, a license agreement looks like a project option if
considered from the viewpoint of a single party, but is an
interactive option if both parties are considered
simultaneously. Likewise, the design of an option between
supplier and user that accounts for the impact on both parties is
an interactive business model option. Another example is the
design of a capital expansion strategy in a capital-intensive
industry where cycles of expansion and contraction are typical (as
discussed in Newsletter 7). Our Stanford program has begun
research in such interactive business model options. The concepts
of real options are helpful in these situations, but additional
concepts are needed. Fortunately, those additional concepts
are available and easy to understand. I believe that this
level of work will have a profound influence on business, for the
issues it addresses are fundamental to business success.
(There is yet another stage of option development, but it is on the
distant horizon.)
I look forward to the continued evolution of this important and
exciting field. And I hope to work with some of you during
this evolution. |